Having Your Cake & Eating It Too

Posted on August 12, 2012

"Emerging market debt trades at “twice the yield of developed country debt and triple the fundamentals.” - Jeffrey Gundlach, 2011

The 1990’s were a difficult time for emerging market debt holders. In 1994 there was the Tequila Crisis in Mexico where the Peso was drastically devalued against the US Dollar as capital fled our sunny neighbor to the south. This was followed up by the Asian Financial Crisis in 1997 and Russia’s devaluation of the Ruble and later outright default on their debt in 1998. Since those tumultuous times, emerging markets have come a long way. Many of these nations have made large strides in improving the legal and regulatory climates, which have brought a degree of stability to their economies and financial systems over the past decade.

So the question now is whether or not it is safe for bond investors to swim in the emerging market waters again. Jeffrey Gundlach, founder and bond savant at Doubleline Capital, seems to think so as pointed out in the opening quote. Unlike equity investors which come in all shapes and sizes, professional bond investors put most of their efforts toward understanding the idiosyncratic fundamentals underpinning every individual investment opportunity before committing capital.

The improving fundamentals in emerging markets versus the deteriorating fundamentals in developed markets like Europe, Japan, and even here in the US are primarily due to the different stages of each market's economic lifecycle. The basic economic lifecycle starts with an innovation which creates a new and growing industry. Growth attracts more competition which leads to greater efficiency and a shakeout of those that can’t compete. Eventually the market matures and capital is redirected toward newer, innovative industries. The ability to capitalize on this cycle is the primary reason why the United States is no longer an “emerging market” like we were 100 years ago when Great Britain was the world’s economic power.

So why can’t the US and the rest of the developed world just wash, rinse, and repeat this cycle to restart the global growth engine? The answer is that it can but it will be much more difficult since these markets are already awash in debt. Consider the following quote from Stephen Cecchetti at the Bank for International Settlements:

Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. Used imprudently and in excess, the result can be disaster.

Keynesian economics, which almost all developed nations ascribe to today, preaches that government spending should increase during economic slowdowns in response to diminishing private sector spending. In order to do that, the government must issue new debt since the income it is receiving off of tax receipts is shrinking in line with the private sector. In theory, this counter cyclical move makes sense as a way to combat the volatility of economic cycles. The problem is that Keynes also believed that the debts incurred during the times of economic stress should be paid down during times of economic growth, which is something developed markets have failed at miserably over the past three decades. Now these markets are awash in debt and no longer have the flexibility to take on more debt to manufacture growth. We’ve seen this play out in spades in Europe as borrowing costs have skyrocketed for marginal and less than credit-worthy sovereigns.

In contrast, emerging markets are not in this same predicament. For starters, by definition, an emerging market is not a mature market. As such, they are still in the growth phase where capital is being funneled toward infrastructure projects to bring these countries up to the developed nation status of the 21st century. In addition, having gone through the “lean years” of the 1980’s and 1990’s, many emerging markets have made some tough, long-term decisions to bring their financial houses in order. Today, their debt to GDP levels are lower and their GDP growth rates are higher than those of the developed world as shown in the first chart.

A low debt to GDP ratio with solid GDP growth gives lenders peace of mind because it shows that the borrower has the means to pay back the debt without devaluation or default. Low debt levels also give countries more flexibility to support a pro-growth agenda. The improvement of the fundamental picture for emerging markets has not been lost on the ratings agencies either. The second chart shows how the ratings of a handful of emerging and developed markets have migrated in opposite directions since the turn of the century. In the mid 1990’s, only 2% of the bonds in the JPMorgan Emerging Markets Bonds Global Diversified index where considered investment grade. Today, over half of the bonds in the index meet that standard.

According to Christopher Philips, a senior investment analyst at Vanguard’s Investment Strategy Group, “the average person holds less than 10 percent of their fixed-income portfolio in foreign bonds.” As more and more investors wake up to the fact that emerging markets offer above average yields at superior fundamentals, we could see a massive shift in capital toward these markets, which would in turn push rates down and be extremely bullish for current holders of EM debt. All in all, we agree with Mr. Gundlach’s assessment of EM debt and have decided to use his Doubleline Emerging Markets Fixed Income Fund (DBLEX & DLENX) to gain exposure to these markets.

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